Conservatives should rethink support for a carbon 'tax swap' deal

Many analysts, including some political conservatives, have endorsed a carbon “tax swap” deal in which the revenues from the new tax would be used to offset existing income or payroll taxes. However, in a new study I show that the economics literature suggests a carbon tax is likely far more damaging to the economy than conventional taxes.

Finally, standard models show that if the U.S. imposes a stiff new carbon tax without cooperation from other major governments—notably India and China—then the economic costs to the U.S. will be greatly amplified while potential environmental gains will be squandered.

The conservative case for a carbon tax swap deal says the government should “tax bads, not goods.” If we could bring in a new carbon tax while simultaneously reducing other taxes, then wouldn’t this boost economic growth while helping to fight global warming?

[pullquote]

The answer, sadly, is no.

The standard view in the peer-reviewed literature is that a carbon tax is more damaging to the economy than conventional payroll or income taxes, because a carbon tax is applied to a narrower base. In order to raise a given amount of revenue from a narrower tax base, the marginal rate of taxation must be higher, meaning it distorts the decisions of consumers and businesses more than conventional taxes do.

What economists specializing in this research have realized is that a new carbon tax will amplify the distortions from pre-existing taxes, so that even if the new revenues were used to reduce income taxes dollar-for-dollar, the economy would still suffer.

A seminal paper in this field estimated that if the environmental damages of carbon emissions were $25/ton, even so the damage to the economy would be so great that the “optimal” revenue-neutral carbon tax should only be a mere $7/ton. And if the government used a portion of the carbon tax revenues for other purposes besides tax relief, the cost/benefit calculus becomes so bad that the “optimal” carbon tax would move toward $0.

Conservatives should take note of this important result. In reality, any carbon tax swap deal will not be “revenue-neutral.” There are already numerous political proposals and academic studies suggesting all the various uses to which carbon tax revenue could be put, including subsidies for “clean energy,” assistance to poorer households to compensate for the carbon tax’s higher energy prices, and of course “deficit reduction.”

For example, a recent Congressional Research Service analysis applauds the ability of a new $20/ton carbon tax to raise $1.2 trillion over the next decade. Thus conservatives are being quite naïve if they trust the government to implement what is effectively a massive new tax on energy, in exchange for equal reductions in income tax rates.

To get an idea of just how economically damaging the CRS proposal would be, consider that in 2012 the CBO estimated that returning income tax rates to Clinton-era levels on those earning over $250,000 would bring in an extra $823 billion over the next decade. Thus the carbon tax proposed above would constitute a tax increase half-again as big, and in a manner far more damaging to the economy. Remember, as bad as the personal income tax is, the best literature suggests that a carbon tax is far worse.

What is most tragic is that a new carbon tax levied by the US (and perhaps European) governments but without the support of China and India would be all pain with little gain. The respected computer model of William Nordhaus—himself a strong proponent of carbon taxes—estimated that if only half of the world’s carbon emitters participate in a tax scheme, then the economic cost of achieving a given environmental goal rises by a whopping 250 percent.

Factoring in technical considerations but also political realities, the case for a carbon tax swap deal is dubious indeed. Conservatives, of all people, should be very skeptical when Washington proposes a massive new energy tax as a reform that will promote efficiency and boost the economy.

Robert P. Murphy has a PhD in economics from New York University and is Senior Economist with the Institute for Energy Research. He is the author of the new study, "Carbon 'Tax Swap' Deals: A Review and Critique."